Capital adjustment costs: Implications for domestic and export sales dynamics

Theoretical and empirical work on export dynamics has generally assumed constant marginal production cost and therefore ignored domestic product market conditions. However, recent studies have documented a negative contemporaneous correlation between firms'domestic and export sales growth, suggesting that firms can be capacity constrained in the short run and face increasing marginal production cost. This paper develops and estimates a dynamic model of export behavior incorporating short-term capacity constraints and endogenous capital investment. Consistent with the empirical evidence, the model features firms' sales substitutions across markets in the short term, and generates time-varying transition paths of firm responses through firms' capital adjustments over time. The model is fit to a panel of plant-level data for Colombian manufacturing industries and used to simulate how firm-responses transition following an exchange-rate devaluation. The results indicate that incorporating capital adjustment costs is quantitatively important. First, it takes more than five years for firms to fully adjust to a permanent change of the exchange-rate process. Second, the long-run exchange rate elasticity of exports is substantially higher than that in the short run. Firms' expectation on the permanence of the policy changes also matters. The failure to accurately anticipate the duration of the devaluation results in reduction in firms' profits due to over- or under-investment in capital.